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Ten considerations in a quality of earnings study
March 25, 2022 · Authored by William A. Chapman
Preparing for a potential acquisition
When entering into a preliminary agreement to purchase a going concern, it is considered prudent for the buyer to contract independent professionals to conduct a quality of earnings report (QoE report) in order to validate the buyer’s investment thesis. A proper quality of earnings analysis encompasses a variety of elements. The following is a short list of considerations when determining the appropriate scope of a quality of earnings study.
1. A quality of earnings study is not an audit
Clients frequently ask why there is a need to perform a quality of earnings study when the subject company is already audited. There are several differences between an audit and a quality of earnings study. Such differences include the following: In a quality of earnings, the focus is on the economic earnings vs. the balance sheet serving as the focus in an audit; a quality of earnings is a consulting engagement, not an attest service, providing flexibility in the approach and scope; and the materiality is much lower in a quality of earnings study than an audit.
2. What gives earnings "quality?"
In order for an earnings measure to be considered of high quality, it must reflect free cash flow and it must be sustainable. Earnings that are “tied up” in accounts receivable, for example, do not have much value because, despite being recognized, they have not yet been realized. In the same vein, earnings that are not sustainable because of understated expenses due to an unfilled executive position, as an example, would overstate sustainable earnings.
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